The Bank of Japan will likely trim its inflation forecasts on Tuesday and consider changes to its massive stimulus programme to make it more sustainable, reflecting a growing recognition it will take longer than expected to meet its elusive price goal.
The central bank has failed to break Japan`s entrenched deflationary mindset despite years of heavy money printing, with stubbornly soft inflation sapping its ammunition and global trade woes clouding the outlook for an export-reliant economy.
But there is uncertainty on how long it can sustain the current ultra-easy policy given the strain near-zero rates are inflicting on Japanese banks and the bond market.
The BOJ`s nine-member board will debate ways to address the conflicting challenges, with options including tweaks to its asset-buying techniques and guidance on its yield targets, say sources familiar with the bank`s thinking.
The changes, although small, would be the latest sign Governor Haruhiko Kuroda is walking away from his radical stimulus programme deployed five years ago to shock the public out of deflation.
"The BOJ may be losing confidence over its ability to drive up inflation. If it had confidence, it could keep insisting that inflation will reach 2 percent at some point," said Izuru Kato, chief economist at Totan Research.
"The only lasting solution for the BOJ would be to make its inflation target a long-term goal. But that could take time and prove difficult."
At the two-day rate review concluding on Tuesday, the board will also discuss how simmering trade tensions between the United States and China could affect global trade and Japan`s export-reliant economy, analysts say.
Data released on Tuesday showed factory output fell 2.1 percent in June to mark the second straight month of declines, though manufacturers expect to increase output in July and August reflecting robust global demand.JITTERY AHEAD OF BOJ
Expectations that the BOJ may announce a tweak in its monetary stimulus weighed on global bond markets, with the U.S. 10-year Treasury yield rising to a six-week high just shy of 3 percent on Monday.
Japan`s 10-year yield hit its highest level in nearly a year and a half on Monday, forcing the BOJ to conduct a special bond buying operation for two straight sessions.
Under its yield curve control (YCC) policy, the BOJ pledges to guide short-term rates at minus 0.1 percent and 10-year bond yields around zero percent.
It also buys risky assets such as exchange-traded funds (ETF) and corporate bonds, and keeps a loose pledge to increase its government bond holdings by 80 trillion yen ($720.79 billion) per year.
Many BOJ policymakers are wary of hiking rates just yet, as inflation remains distant from their target and markets are jittery of any sign central banks are whittling down stimulus.
The central bank may instead tweak its guidance on the yield targets to signal it would allow rates to move more flexibly, the sources say.
It may also modify the way it buys risky assets such as ETFs, nodding to concerns its purchases are distorting markets.
The BOJ meeting would precede the U.S. Federal Reserve`s two-day rate review through Wednesday, which is expected to reaffirm the outlook for further gradual rate rises.
In a quarterly review of its projections on Tuesday, the BOJ is set to trim its price forecasts and concede inflation could fall short of its target for three more years.
Governor Kuroda is expected to hold a media briefing at 3:30 p.m. (0630GMT) to explain the policy decision.($1 = 110.9900 yen)
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